UPDATE 1-State regulator rejects Avista's sale to Canada's Hydro One

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(Adds response from companies)

Dec 5 (Reuters) - A Washington state regulator on Wednesday rejected Canadian electric utility Hydro One Ltd's proposed acquisition of rival Avista Corp, saying the deal would not adequately protect Avista or its customers from political and financial risk.

Hydro One proposed to buy Avista for C$6.7 billion ($5.02 billion) in 2017 as it sought to expand into the U.S. Northwest.

"The proposed transaction cannot be said to be consistent with the public interest when it is evident that decisions affecting Hydro One's and Avista's business operations and financial integrity are subject to political considerations," the Washington Utilities and Transportation Commission said here

Hydro One and Avista acknowledged the decision in a joint statement.

"The companies are extremely disappointed in the UTC's decision, are reviewing the order in detail and will determine the appropriate next steps," they said.

The Ontario provincial government owns 47 percent of Hydro One, and the regulator said that Hydro One had described the province as a passive investor. But after the Ontario provincial election in June, the province and Hydro One announced an agreement that led to the replacement of the company's board and the retirement of its chief executive officer, the regulator said.

The commission said those changes put the government's political interests above those of other stakeholders, including investors that owned 53 percent of Hydro One.

"Provincial government interference in Hydro One's affairs, the risk of which has been shown by events to be significant, could result in direct or indirect harm to Avista if it were acquired by Hydro One," the commission said.